The story of Silicon Valley Bank’s failure has now been told many times, from many different angles. What follows is merely my synthesis of all these different stories, structured in a form that makes sense to me.
This is one of those posts which will irritate nearly everyone, because I apportion blame among all the players. I don’t think any of the principal characters—the regulators, the bank, the venture capitalists, or the entrepreneurs—look especially good here. Ex post analysis is easier than ex ante analysis, and yet, I think it’s instructive to figure out how it all went down. This analysis won’t fix the issue, and tomorrow’s bank run will have a different cause. Further, regulators and their politician enablers are, as with generals, always fighting the last war. So I don’t expect anything to change from this analysis. Nonetheless, I do think it’s a useful exericse.
On to the players.
The regulators (and politicians)
Fractional reserve banking doesn’t work well, given the velocity with which information travels these days. The Fed’s upcoming implementation of FedNow will only exacerbate this issue. Capital requirements have to increase.
Our regulatory structure is too inflexible and too outdated to contend with the potentially explosive combination of fast information flows and highly leveraged bank balance sheets.
Bank runs are mimetic events. And the Silicon Valley Bank run happened at the speed of Twitter, which is to say, at the speed of the internet. No stately affair was this. Venture capitalists panicked, in part due to poor communication from the bank about its efforts to shore up its balance sheet (about which see below), and they took to Twitter to raise a hue and a cry. Entrepreneurs panicked, in part due to seeing the VCs on Twitter panic, and in part due to private communications the panicked VCs sent to them. Hilarity ensued as they say. The regulators didn’t stand a chance.
Back in 2018, the economist Tyler Cowen published a short and prescient essay, Two American Power Centers are about to Clash. The two “power centers” are Silicon Valley and Washington, DC. Cowen notes:
The D.C. area is the center of legalistic thinking, which is increasingly important with the growth of government and the regulatory state. Lawmakers and policy-makers are our engineers for incentives, so to speak, even if they don’t always get it right. Their efforts are backed by an array of economic, legal, political, public opinion and bureaucratic expertise that is without parallel in history. If, for instance, you talk to the specialist at the Treasury Department on accelerated tax depreciation, that individual will be impressive, even though his or her final output may be filtered through some very unimpressive political constraints.
…
The Bay Area is full of engineers of the more literal sort, producing rapidly scalable goods and services, at least once the initial code is cracked. It’s given us operating systems, internet search and browsers, personal computers, ride-sharing apps, Facebook, Amazon delivery and much more. It’s the old American “can-do” mentality, but accelerated and intensified by Moore’s law, with new methods for organizing and motivating talent. And it is realized in the less regulated parts of the economy, where companies can get something done without first requiring too much permission from America’s other intellectual center.
Because these two power centers have such different frames of reference, and because they rarely talk to one another, neither side really understands its counterpart. So you had very well-connected venture capitalits with large Twitter audiences shouting at millions of followers. And you had buttoned-up regulators and politicians sitting in their cloistered offices a few thousand miles away. And never, to quote Kipling, shall the twain meet.
Regulators have to up their game. Information flows very quickly these days. This is not the S&L crisis, or even the Global Financial Crisis. This is internet time, and regulators had better grok silicon.
The bank
Silicon Valley Bank was an unusual bank. Its depositor base was less diverse than other banks of its size. Its depositors were mainly venture capitalists and the companies in which they invested. When interest rates were low, and venture capitalists were still interested in funding startups that didn’t generate free cash flow, this was not a problem. But when interest rates rose, correlations converged on one and all hell broke loose.
To make this more concrete, as interest rates rose, venture capitalists started to become much more selective about which companies they would continue to support with regular cash infusions. And, to the venture capitalists’ credit, they conveyed this messaging pretty explicitly to the entrepreneurs in whom they invested. But what they, and crucially, the bank, apparently did not understand is that if venture capitalists stop funding companies, and the companies don’t generate free cash flow from their operations, then all of the companies are going to suddenly start withdrawing large amounts of cash from their bank accounts at the same time.
If a bank has a diverse depositor base, this shouldn’t be a problem. But Silicon Valley Bank didn’t have a diverse depositor base. As I mentioned above, its depositor base was mainly technology startups and the venture capitalists who invested in them. And, when correlations converge on one, funny things start to happen. The bank should have been more aware of the connection between rising interest rates and its depositors’ cash withdrawal needs. When depositors demand more cash than a bank can supply, a bank run is imminent.
And, when the bank belatedly realized this issue, it decided to try to raise additional equity capital to meet its depositors’ withdrawal needs. But the bank didn’t communicate this well, venture capitalists panicked and sowed panic among the entrepreneurs in whom they invested, and, well, bank runs are mimetic. And mimesis at internet speed is a volatile event.
The venture capitalists
Venture capitalists like to position themselves as savvy investors who have seen it all. And yet, they apparently do not understand how fractional reserve banking, the very money management system on which they and their companies vitally depend, works. To say that this beggars belief is to understate the case. Nonetheless, this is an important piece of the puzzle.
Venture capitalists took to Twitter, irate at Silicon Valley Bank and federal banking regulators, saying “it wasn’t their job” to understand bank balance sheets, or the fact that companies couldn’t withdraw cash that the bank said the company had deposited with it. But here’s the thing: that’s how fractional reserve banking works. When you deposit cash with a fractional reserve bank, you are loaning the bank your cash in exchange for a (tiny) interest rate. And because it’s a demand deposit, the depositor can demand all or a portion of its cash at any time.
This is banking 101.
Venture capitalists should not have insisted that the companies in which they invest do their banking at the same bank. They should have insisted on a diversity of banks. Further they should have insisted that their companies’ CEOs set up sweep accounts which swept cash in excess of FDIC insurance limits into non-bank cash equivalent products like money market funds. This is standard cash management practice at literally every company out there. Except, apparently, tech startups funded by venture capitalists who claim that they don’t understand how banking works.
Entrepreneurs
The one party in all of this who has a reasonable claim to not understanding how banking works is the entrepreneurs. I don’t want to spend a lot of time shitting on them, because they were the ones who scrambled to meet payroll and pay for other crucial operating expenses.
Here’s the thing: an entrepreneur should never rely on her investor(s) brokering banking (or legal) relationships. The entrepreneur should select her own bank. And the entrepreneur should set up banking such that cash balances in excess of $250,000 are swept into money market funds.
Former AOL CEO Steve Case wrote an opinion piece in the Washington Post recently, saying that after the failure of Silicon Valley Bank, entrepreneurs need an entrepreneur-friendly bank. While this is true, and while it is also true the entrepreneurs and venture capitalists probably don’t have a lot of great banking options given what happened with Silicon Valley Bank, venture capitalists and entrepreneurs need to get a hell of a lot smarter about how banking works.
I’m all for criticizing fractional reserve banking, and observing how it and the regulatory apparatus that has been erected around it, is inflexible and unsuitable for today’s needs. But betting on change, or regulators and/or politicians seeing the need for change, is a bad bet. Venture capitalists and entrepreneurs have to learn better cash management practices.
After I posted this, I asked ChatGPT to present some counterarguments. As you may have surmised, mine is a very one-sided view of the bank failure. While I think that these counterarguments are all fair, and probably worth your consideration, I also don’t think that any of them disprove the claims I make above.
Here are its suggestions:
Some counterarguments to the points presented in the analysis of Silicon Valley Bank's failure are:
Regulators: Critics might argue that the responsibility of regulators is to ensure stability and not to constantly adapt to changing information flows. They may also contend that regulators cannot be blamed for the mismanagement of a single bank and that expecting regulators to predict and prevent every crisis is unrealistic.
Silicon Valley Bank: Some may argue that the bank's unique business model and focus on technology startups and venture capitalists were part of its appeal and differentiation in the market. Critics might also claim that the bank's actions were rational given its unique customer base, and that it's impossible to predict all market changes.
Venture capitalists: Defenders of venture capitalists might point out that their primary focus is on investing in and supporting innovative startups, not on understanding the intricacies of banking. They could argue that expecting venture capitalists to be experts in banking and cash management is unreasonable, as their main expertise lies in identifying promising businesses and helping them grow.
Entrepreneurs: Some might argue that entrepreneurs should focus on building their businesses and not be expected to have a deep understanding of banking and cash management practices. It could also be contended that entrepreneurs should be able to trust their investors and banks to manage these aspects on their behalf, allowing them to concentrate on their core business operations.
Overall, these counterarguments suggest that while each party may have some responsibility in the failure of Silicon Valley Bank, it is not fair to place the entire blame on any single group. Instead, the failure could be seen as a result of a complex interplay of factors involving all parties, as well as broader market dynamics and unforeseen events.